Purchasing Employer Securities

In general, Sections 406 and 407 of the new Act prohibit the purchase of employer stock from a party-in-interest, which includes the employer corporation and any controlling shareholder.” In the case of an eligible individual account plan (i.e. stock bonus plan or ESOP), however, Section 408(e) specifically permits the purchase of employer securities from a party-in-interest so long as the purchase is for not more than adequate consideration.” Therefore, under an ESOP employer stock may be purchased from the company, on the open market, or from individual shareholders, including controlling shareholders. Thus an ESOP, unlike other plans, may be used to enable the employees to acquire a larger block of company stock than could otherwise be acquired if the plan were prohibited from purchasing from the company or from controlling shareholders.

In addition, from the standpoint of a controlling shareholder who sells less than his entire holdings to an ESOP, the sale qualifies as a sale and is not deemed to be a redemption by the corporation, since the trust is an independent entity. This author, for example, recently obtained a private letter ruling holding that the sale to the ESOP was a purchase by it and not a Section 302 redemption by the corporation. It is this feature of the ESOP which gives rise to its use in connection with estate planning for owners of privately held companies.

Debt Financed Acquisitions

The concept of having an employee’s trust borrow funds or otherwise obtain financing for the purpose of making investments is not new. As early as 1953 Rev. Rul. 46, CB. 1953-1,287 gave specific authority for an employee’s trust to borrow to invest in securities of the employer. This ruling was subsequently reaffirmed in 1971 in Rev. Rul. 71-311, I.R.B. 1971-29,86. This ruling has now been narrowed by provisions of the new Act, Section 406(a)( I)(A) of the Act now prohibits other types of qualified plans from engaging in any transaction which constitutes a direct or indirect “lending of money or other extension of credit between the plan and a party-in-interest.” If these provisions applied to an ESOP, an ESOP would be prohibited from purchasing employer stock from a controlling shareholder on an installment sale basis, and a bank loan could be obtained only if the trust were, able to obtain the loan without the employer company’s guarantee, Section 408(b)(3), however, specifically exempts an ESOP from this prohibition, provided that the loan is primarily for the benefit of participants and the interest rate is not in excess of a reasonable rate.”

In a growing company, an ESOP is almost always more beneficial to employees than an ordinary stock bonus plan. With a stock bonus plan, each year’s annual contribution must be used to purchase or acquire stock at its then present fair market value. An ESOP, on the other hand, by utilizing financing enables the trust to obtain ownership of a block of shares at the fair market value of the stock on the date of purchase. Hence, under an ESOP the trust is able to acquire a larger block of stock than could be purchased with a single year’s contributions. As a result, there is a larger investment that is subject to appreciation and the appreciation occurs over a longer period of time, In addition, employee incentive is greatly enhanced due to the fact that the employees have not merely an unspecified commitment from the company to make future contributions, but, in effect, have a funded trust and an identifiable interest in specifically segregated trust assets which can be “earned-out” by them over a period of years.


Distributions under an ESOP are made in much the same number as under a profit-sharing plan, Benefits may be distributed at retirement or death, upon disability, illness, lay-off, financial hardship, severance, or attainment of a stated age, or after a fixed number of years of participation in the plan (subject to a minimum period of participation of 2 years). Like a profit-sharing plan, distributions may be made either in a lump-sum or in installments, A lump-sum distribution of employer stock, however, is especially advantageous in that the unrealized appreciation is entitled to capital gains treatment when the employee sells the stock.

In order to provide a source of stock for future participants in the plan and to provide a market for shares distributed to terminated employees, the ESOP plan frequently provides for two special options on distributed shares. Under the first option, the company and or the trustee is given a “right of first refusal” to repurchase the stock if the employee decides to sell or transfer any of his stock. Under the second option. the employee is granted a “put” to sell his shares to the company and lor the trust within one year of distribution.

Plan Consolidations

Frequently it is desirable to suspend and replace an existing profit-sharing plan with an ESOP so that future contributions may be made in company stock or may be used to acquire an available block of stock for the employees. Similarly. in certain instances it may be desirable to suspend and replace an existing fixed benefit pension plan or money purchase pension plan with a combination stock bonus plan and money purchase pension plan. Properly structured. such plan consolidations do not result in a termination of the prior plan if the successor plan qualifies as a comparable plan under Reg. 1.401-6(b) and if, under Section 208 of the Pension Act, the benefit which a participant would receive if the plan then terminated is at least equal to the benefit he would have received if the plan had terminated prior to the consolidation.

Other Aspects

Under the ESOP plan, all voting rights on company stock held by the trust are exercised by the plan committee, which is appointed by the company’s Board of Directors. Voting rights on vested shares may, however. be passed through to the employees if the company so provides in the ESOP plan. In the alternative. the company may permit one or more employee representatives to serve on the plan committee.

So long as the plan is non-contributory and employees have no right to determine the manner of distribution under the plan, shares issued under the plan do not involve a “sale” or “offer to sell” within the meaning of Section 2(3) of the 1933 Act. This conclusion has been confirmed by a recent SEC no-action letter.

In adopting an ESOP, consideration should also be given to such matters as debt-financed income, allocation formulas for the allocation of interest expense, the treatment of dividends on unallocated shares and the distribution of pledged shares.


The ESOP is a complex but highly flexible tool. Because the ESOP concept is new and because the accounting procedures and method of allocating stocks differ from the methods and procedures used in an ordinary stock bonus plan or profit-sharing plan, the ESOP must be very carefully designed in order to avoid IRS difficulties. (I/R Code No. 2400.00)


Mechanics of the ESOP Plan

Statutory Definition

The term “employee stock ownership plan” is a newly-defined term under the Pension Reform Act. Under Section 407(a)(6) of the Act, the term is defined to mean an individual account plan “which is a stock bonus plan which is qualified or a stock bonus plan and money purchase pension plan both of which are qualified under Section 401 of the Internal Revenue Code of 1954, and which is designed to invest primarily in qualifying employer securities . . .” The term “eligible individual account plan” is defined by Section 407(d)(3)(a) of the Act to mean an “individual account plan which is (i) a profit-sharing, stock bonus, thrift or savings plan; or (ii) an employee stock ownership plan; … ” From the foregoing it is apparent that the central vehicle of an ESOP is the stock bonus plan.

A stock bonus plan is a qualified plan referred to in Section 40l(a) of the Internal Revenue Code along with pension and profit-sharing plans. Like a profit-sharing plan. the basic deduction limit for contributions to a stock bonus plan is 15% of compensation and annual additions, including contribution carryovers to a participant’s account, and may not exceed the lesser of $25,000 or 25% of a participant’s compensation. A stock bonus plan is defined in the Regulations as being a plan, which provides benefits “similar to those of a profit-sharing plan except that the contributions by the employer are not necessarily dependent upon profits and the benefits are distributable in stock of the employer company. ” Thus the two features that distinguish a stock bonus from a profit-sharing plan are that under a stock bonus plan company contributions need not be dependent upon profits. and benefits must be distributable in employer stock. The first feature means that the employer company may obligate itself to make contributions to a stock bonus plan irrespective of profits. It is this feature, which enables a stock bonus plan, unlike a profit-sharing plan, to engage in debt financing. The second feature means that while the investment of contributions in stock of the employer prior to the time of distribution of benefits is not specifically mandated, the trust must at a minimum acquire sufficient stock of the employer company to make the required distributions of company stock under the plan.

On the other hand, in recognition of the fact that the primary purpose of the stock bonus plan is employee incentive rather than retirement security, a stock bonus plan, unlike an ordinary profit-sharing plan, may be entirely invested in employer securities.

Acquiring and Holding Company Stock

The Exclusive Benefit Rule. Under Rev. Rul. 69-494, I.R.B. 1969-38, 9, the investment of funds of an exempt employee’s trust in stock of the employer corporation will violate the “exclusive benefit of employees” rule unless the investment meets the following four investment requisites: (1) the cost of the investment must not exceed its fair market value; (2) a fair return must be provided; (3) sufficient liquidity must be maintained to permit distributions in accordance’ with the terms of the plan; and (4) the safeguards and diversity that a prudent investor would adhere to must be provided. In the case of a stock bonus plan, the requirement of a fair return is specifically waived by Rev. Rul. 69-65, I.R.B. 1969·7,9. Similarly, since a stock bonus plan is designed to be primarily invested in employer securities and to permit distributions of employer stock, the very nature of a stock bonus plan eliminates the third and fourth requirements. Accordingly, the principal investment requisite in the case of a stock bonus plan is the requirement the stock be acquired for not more than adequate consideration. Because valuation is the principal investment requisite and because valuation frequently depends upon intangible factors, it is strongly recommended that the stock be valued by an independent appraiser. Further, the valuation method, once determined, should be consistently applied bath for purposes of contributions and for purposes of distributions.

The investment requisites of Rev. Rul. 69-494 have now been codified by Section 404(a) of the Pension Reform Act. In addition, Section 407(a) of the Act specifically prohibits ordinary pension and profit sharing plans from acquiring or holding more than 10% of the fair market value of plan assets in employer securities and employer real property, and requites such plans to dispose of at least 50% of their excess holdings by December 31,1979. Section 407(b), however, specifically exempts an eligible individual account plan, as defined in Section 407(d)(3), from this diversification requirement. Under Section 407(d)(3) an eligible individual account plan includes a stock bonus plan and employee stock ownership plan. It also includes a profit-sharing plan which is an individual account plan and which explicitly provides for the acquisition and holding of qualifying employer securities. (In effect, a profit sharing plan may qualify only if it uses individual accounts and follows accounting and allocation rules similar to those of a stock bonus plan.) Moreover, Section 407(d)(3)(B) permits a qualified plan to continue to hold excess employer securities if the plan is converted into an eligible individual account plan within one year from January 1, 1975.

Contributions of an ESOP

Because the ESOP is not restricted in acquiring employer securities or employer real property, contributions to an ESOP may be made entirely in common and/or preferred stock of the employer or in employer real estate. Contributions need not, however, be made entirely in employer property. Contributions may also be made in cash, in non-employer stock, in non-employer real property, or in any combination of the foregoing. A contribution of employer stock, however, is usually preferable to a contribution in kind of other property, since a contribution of other property results in taxable gain to the employer to the extent the fair market value of the property exceeds basis.

Contributions of employer stock are frequently combined with cash contributions. Cash contributions may be accumulated to acquire additional stock when available, to repurchase stock from terminating employees, to purchase key-man or buy-sell insurance, or to make temporary income producing investments.

Another significant feature of the Act is that the Act defines the term “employee stock ownership plan” to include a combination stock bonus plan and money purchase pension plan. This means that contributions of up to 25% of compensation may be made to an ESOP, without using contribution carryovers, since the deduction limit for a qualified combination plan is 25% of compensation.


The Employee Stock Ownership Plan: a New Trend in Employee Benefits and Corporate Finance (Part I)

August 28, 2012

An increasing number of companies are turning to employee stock ownership plan financing as a means to simultaneously raise low cost capital and provide increased employee incentives and retirement benefits while reducing the cost of qualified plan benefits. The employee stock ownership plan is a qualified plan under Section 401(a) of the Internal Revenue Code. […]

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My Plan to Buy Stock

August 28, 2012

People often ask me how I was able to retire at such a young age. I retired when I was in my late thirties. Most people expect to work till they are in their fifties at least. I am very lucky because I made some very good investments which have allowed me to retire early. […]

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My Big Decision

August 28, 2012

I have recently had a very big decision to make. Two years ago I joined a new company. It took me a while to settle in but eventually I started to enjoy the work. There has been a probation period of two years. Now that I have passed the probation period I am eligible to […]

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My Stock Selection Choice

August 28, 2012

There has been a lot of coverage in the press recently about global financial problems. For several years it has seemed that the world economy has been in trouble. It has not been a good time for investors to put their money in to equities. So it is normal that many employees choose not to […]

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Picking the Right ESOP

August 28, 2012

Many people ask my advice about which ESOP (an abbreviation of the term employee stock ownership plan) they should choose. When most people are given the option of purchasing stock by their employer they are not sure what to do. It can be difficult to know if it is the right financial decision. There are […]

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Choosing a Stock Plan

August 28, 2012

I have recently been asked by my employer to gather some data on which ESOP plan is the best choice for our company. This was not an easy task for me. In fact it required a lot of detailed research. I started off my research by visiting the library. I looked up a number of […]

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22 ESOP Misconceptions and Myths Part I

August 23, 2012

ESOPs were initially approved by federal government law during 1974. From that day, there have been over 25 individual bits of rules which have additionally described what an ESOP is and how much of an ESOP is allowed to do. In spite of this fact, there are more myths regarding ESOPs than regarding any of […]

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22 ESOP Misconceptions and Myths Part II

August 23, 2012

Myth #12: The custodians of an ESOP have got a greater level of fiduciary responsibility than do custodians of other kinds of worker benefit programs Incorrect. In fact, the custodians of an ESOP have got a lesser risk of fiduciary responsibility because of the character of an ESOP. In ERISA an ESOP, in contrast to […]

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